3,000 clocked up and more to come: Belief that economic conditions are right for a sustained recovery took the UK stock market to last week's record levels. Richard Thomson reports

IT LOOKED as if the stock market had taken leave of its senses or was - at the very least - in the grip of an irrational passion.

On Tuesday, BOC issued a profits warning and a gloomy view of the world economy. On Wednesday, the Confederation of British Industry published a report suggesting that the recovery in UK manufacturing was faltering. The unemployment figures, meanwhile, showed a small but unexpected rise.

Yet amid all this gloom, the stock market surged to record highs. The excitement began on Monday and steadily gathered pace. The FT-SE 100 index jumped 34.5 points on Wednesday, pushing it above 3,000 for the first time. It closed triumphantly on Friday at an all-time high of 3,010.

Breaking the 3,000 barrier was a significant moment. Looking back over 10 years, investors had reason to celebrate. The market has shown a remarkably steady rise, trebling in value since 1983. Even the 1987 crash looks like little more than a blip in the upward march of share prices. Only a few weeks ago, analysts were not expecting 3,000 to be reached before the end of the year. Most now expect around 3,200 by Christmas, while some, including Nomura, foresee 3,500.

Inevitably, the City was jumping for joy. The stock market had not seen this kind of action for months, although there was little evidence of the kind of feeding frenzy that investors sometimes display when share prices move fast. Thursday was the busiest trading day so far this year, with 900 million shares changing hands in 45,500 bargains - but even this was less than the turnover that followed sterling's exit from the exchange rate mechanism last year.

Strikingly, the charge was led by small investors. Institutions have already invested fairly heavily in equities, but small investors have taken longer to regain their confidence in the market. Over the past few months, money has been flooding into unit trusts in a way not seen since the 1980s. In the second quarter of this year, unit trust purchases were pounds 2.5bn - four times the level for the same period last year and the second highest quarterly inflow on record (the highest was in the months just before the 1987 crash).

'It has taken small investors a bit of time to get interested,' said Rachel Medill, an executive with M&G, the fund managers. 'Investment hasn't been frantic but steadily increasing through PEPs, insurance bonds and direct unit buying.' M&G's popular managed income fund, for instance, has taken in pounds 60m since March.

But have investors gone mad by ignoring the gloomy economic news, or is there method in their enthusiasm?

Characteristically, the stock market is looking forward and anticipating. It sees promising economic recovery and rising company profits ahead.

Almost since the beginning of this year, share prices have been drifting, waiting for clear signs of economic recovery. As the French franc gave way on the foreign exchanges, it became clear that lower European interest rates were on the way. That, argued the optimists, would help European economies out of recession and be good news for UK exporters. Moreover, it should also lead to lower UK interest rates, helping UK industry at home. 'We expect rates to be down to 4.5 per cent by the year end,' said Paul Walton, equity strategist at James Capel. This would be the lowest level for about 30 years.

And, for the first time in nearly as long, Britain is heading out of recession with a low inflation rate, likely to remain between 1 and 4 per cent for the foreseeable future. The Bank of England gave its blessing to this view in an encouraging economic outlook last week.

Low inflation together with low interest rates is the magic economic combination - no wonder it set the market's pulse racing. The underlying conviction that recovery is at last a reality was reflected in the share price rises. Although the 100-share index rose strongly, it was overshadowed by the FT-SE 250 index of medium-sized companies. Since hopes of recovery were kindled by sterling's withdrawal from the ERM last September, the FT-SE 100 has risen 25 per cent. The 250 index, meanwhile, has soared 58 per cent.

The 100 index is made up of blue chips with large overseas earnings - good defensive investments when economic times are hard. But the mood has steadily turned against them. Over the last year, pharmaceuticals have underperformed the market by 30 per cent while food retailers - the popular sector during the recession - have underperformed by 15 per cent.

Companies in the 250 index, however, are more cyclical - such as building, contracting, and motor stocks - with a greater exposure to the domestic economy. They represent the real recovery play.

But with such dramatic price rises, is the market getting ahead of itself? Is it as speculative and frothy as some commentators claim?

'Average equity yields are usually above 4 per cent, but now they've fallen to around 3.4 per cent,' said Richard Curzely, equity analyst at BZW. But he pointed out that this does not prove the market has over-reached itself. The last time there were fears that the market was rising too far was just before the crash. But conditions are fundamentally different now. Six years ago, prices were being driven by the boom. When the market lost confidence in the boom, the stock market collapsed. This time, it is the low inflation/low interest rate economy that is underpinning the market - a far more secure foundation, analysts believe, for rising share prices. Moreover, with interest rates so low, shares still represent good value against cash deposits. And in comparison with the bond market, where yields have dropped to their lowest for more than 20 years, equities have merely been keeping pace.

Thanks to low interest rates and low inflation, the gilts market has soared. In the last six months, yields on the benchmark long-dated gilts (those with 20-year maturities) have fallen from 9 per cent to below 7.5 per cent. Traditionally, long-bond yields are a little over twice the yield on equities. The recent drop in equity yields, therefore, simply maintains the normal relationship between the two markets.

It is partly the very success of the Government's gilts sales that gives some reassurance that the rise in shares is not speculative or frothy. The Government has persuaded investors that despite its pounds 50bn funding requirement, its bonds are a good investment. Partly by hinting that it will reduce the deficit through tax increases in the next Budget, it has persuaded UK and overseas institutions to invest heavily.

It has managed the impressive feat of raising pounds 29bn from gilts - 60 per cent of this year's total - within the first four and a half months. A huge chunk of institutional investors' money, therefore, has been diverted from shares into gilts.

A further chunk of institutional cash has been soaked up by pounds 10bn of rights issues so far this year. With about pounds 40bn absorbed in bonds and rights issues, the stock market's sluggishness earlier this year is not hard to explain. But the reasons also suggest that there is not much surplus cash at present to create superficial speculative surges on the stock market.

On the other hand, with government debt funding more than half complete and with the pace of company rights issues likely to slacken for the rest of this year, Mr Walton believes there should be more investment money available to support share prices at their current levels or push them even higher.

But the sceptics remain concerned that shares values are getting overstretched. Their worry is that company earnings will simply not be high enough to justify the share ratings - in other words, that the market is overestimating the strength of recovery.

'The interim reporting season over the next few weeks will be critical,' Tony Baccardo, investment strategist at Nomura, said.

'Analysts have been talking down company results over the last few months. But we believe companies have made a good fist of the competititve challenge of the recession and that most company results will be good.'

Most other stockbrokers have come to a similar conclusion despite the profits warning from BOC. 'All it needs to justify these share ratings is an average earnings growth of around 15 per cent,' Mr Baccardo said. 'And that's exactly what we're likely to get.' He believes corporate earnings are set to rise by 15.5 per cent this year, another 15 per cent in 1994 and only slightly less than that in 1995.

According to Mr Walton, the current valuations are still relatively low. The average ratio of share prices to company earnings is about 14 times, well below the dizzy peak of more than 20 times reached before the 1987 crash. The market fell in 1987 because its sensed that interest rates and inflation were on the rise. This time, there is no such fear.

Mr Walton considers there are three factors that could trip the stock market up, although none of them is particularly likely to happen. John Major may return from his holidays and proceed to plunge the Government into crisis again; commodity prices - oil in particular - might soar, putting pressure on recovery; or the US stock market, which has also been riding high, might catch a cold that would immediately transmit itself to London.

Assuming none of these mishaps occurs, the London stock market looks as though it has reached a new trading level.

It may hover around the 3,000 level for some time, but there is very little reason to expect it to fall back significantly. There is, however, good reason to believe the market will continue to rise modestly. Welcome to recovery.

(Photographs and graphs omitted)